The Franchise Value Bubble is Poised to Pop

Yesterday I ran two posts about potential unrest in the Land of the Lords of the Realm. You can read them here and here. Upshot: even billionaire playboys are not immune to the current economic downturn, and in fact they are particularly vulnerable if they either (a) depend on real estate for their fortune or cash flow; or (b) need cash right now. Upshot of the upshot: it seems inescapable to me that franchise values are or should be falling, and that absent artificial prop-jobs like the Moorad-Moores deal, owners are going to take baths on the resale of their franchises for the foreseeable future. That, in turn, will likely have some depressing effects on salaries and other spending by baseball teams.

In response to the second piece, your friend and mine, Jason from IIATMS, had this to say:

Last I checked, there were many mega-rich left standing, even with the market, Madoff, TARP, AIG, etc.

There will always be someone willing to belly up to the bar for a chance at owning a baseball team. Never underestimate the power of ego when combined with mad riches.

I think Jason is generally right about that, but the key is not whether there are willing buyers out there, it’s the price at which these ego-driven buyers will ultimately offer. My very good friend Ethan Stock — whose mostly technology but occasionally political blog can be found here and whose very cool business can be found here — feels the same way. Except, unlike me, he’s smart enough to flesh out that observation in detail, and he has forwarded that fleshing out to me. I now offer it as a guest post. Take it away Ethan:

I read Jason from IIATMS’ first comment and, with all due respect, here’s Jason, the shorter version: “Prices can’t fall here, because this is a really nice neighborhood”.

‘Here’ being, say, San Francisco. Or Manhattan. Or Miami Beach.

Sure, there are a lot of mega-rich left standing. But they are the smarter ones, and they are smarting, and while they may jump at the chance to own a baseball franchise, it is extremely likely that they will not jump quite so high. Craig is exactly right in the comments that Cuban was saved by Selig, and is no doubt counting his lucky stars. If Cuban has invested his money wisely in the meantime, my prediction is that he will be a baseball owner by 2015 at ½ the price at which he intended to buy the Cubs.

So much of the “mad riches” out there — the sorts of riches the ego-driven types who tend to like owning baseball teams tend to have — was built on the back of leverage, leverage, leverage. All of which is collapsing like ninepins. Check out the factors that have been leveraging up the value of major-league franchises (I include the NFL in this, and slightly the NBA) and which are now leveraging those same values down:

1) The aforementioned real estate factor. A stadium/team is often an explicit license to develop around – entertainment, retail, office buildings, apartments and condos. The model invented by the Rangers in the early 90s with the Ballpark at Arlington. And nothing has been hotter than real estate. Brrrr. Feel the chill?

2) The oft-by-Shyster mentioned stupid-government-giveaways factor. Since the late 80s, buying a team has been a near-guarantee that some municipality will gift you with concessions worth about $300 million. Think that didn’t add $300 million to the value of a team? Of course it did. Now that just about every municipality has either completed such giveaways — and with municipal bankruptcies looming and the mob sharpening its pitchforks — the days in which cities magically grant owners increased franchise value are as long gone as a hanging curve to Ted Williams.

3) Media advertising has been in a perfect bubble – basically all of the old (newspapers, local TV) plus all of the new (satellite, Internet, broadcast TV, naming rights, etc.) existed simultaneously over the Bush era, despite being on crossing escalators; and it all paid up for sports content because every outlet was fighting alternately for survival or for growth. The whole sectors is now blowing up. Not only is total advertising spend collapsing, the number of media outlets is, too. Think that won’t affect rights bidding and therefore franchise values? Think again.

4) “Rich guy growth” – the fans. There has been unprecedented-since-the-Gilded Era growth in the top quintile takings of salary and investment income, and the people who get that kind of income like baseball. A good percentage of these folks spent kilobucks on fancy box seats and luxury boxes; and all those same guys, not incidentally, are the potential Patek Philippe-wearing walking wallets that the media/advertising complex has been overpaying sports owners to reach. The whole demographic is imploding faster than you can say “the bear market ate Bear Stearns”.

5) “Wannabe rich guy growth” – more fans. There’s a concept called MEW – mortgage equity withdrawal – that has been skyrocketing and is now plummeting. It’s basically the home-as-ATM factor. Popular wisdom has it that a lot of that dough got spent on hot tubs, vacations, SUVs, plasma TVs, and so forth. Do you really think that Joe Bosox didn’t drop any of that dough on his favorite team, paying up for the leavings after the box-seat set had spent their fill? From seat licenses to over-priced jerseys and increasingly ephemeral caps to consuming advertising on that MEW plasma to justify the media bubble, that guy has been doing his share. And now he’s done.

6) “Super rich guy growth” – potential owners. Again, not since the Gilded Age have so many plutocrats been newly minted or re-struck at a higher value. Guys like Stephen Schwarzman were bandied about as potential Cubs buyers. Who the ####? He was nobody 10 years ago and he’ll be nobody 10 years from now. In the meantime he and a hundred other guys like him have been throwing sharp platinum elbows to differentiate themselves from every other arriviste on the Forbes billionaire list. Half of them will be gone this year, another quarter next year, and the number of the guys who can belly up to the bar outside of 2-for-1 happy hour and order a franchise, on the rocks or straight up, will plummet.

7) Creative DCF (discounted cash flow) financing – is no more. From 2004 – 2007 we have seen the apotheosis of DCF – projecting ad infinitum, without risk, the present value of future cashflow to justify the most outlandish purchases at the most inflated prices – all backed by the cupidity of bankers trying to make an extra buck (so they could buy season box seats, of course). Image: Stuyvesant Place in NYC, one of the biggest commercial real estate transactions of all time, sold by Met Life at the top of the commercial real estate bubble, was cashflow negative from the instant the deal closed; and will end up in bankruptcy. Image: Sam Zell’s near-legendary purchase of Tribune happened about the same time, doomed to bankruptcy within 12 months. Cuban’s purchase of the Cubs would have been a third snapshot in this sad album, but oh-so-luckily got zorched by Selig. With trillions of “toxic assets” (translation – the retail version of the wholesale insanity I’ve just described) weighing down the rusty holds of the leaking vessels of American banking, do we really believe that similar creative, nay, gullible financing will be available to *anyone* looking to pay an inflated price for a franchise in the future?

Seven simple pieces of a single fact. Artificial leverage is imploding, and most franchises are “worth” perhaps a quarter of the sticker price they might have brought in 2006.

I’m not sure what to make of Ethan’s estimate of franchise values going down 75% — seems high to me on some gut level — but Ethan is about the smartest guy I’ve ever met. He was talking about the housing bubble bursting before most of us were even aware of the bubble to begin with, and I think he’s dead on with respect to the overall dynamics at play with franchise values as well.

What would the Padres go for on the open market today? What would the A’s bring if Wolff had to liquidate tomorrow? Not every team comes complete with a license to print broadcasting and merchandising bucks like the Yankees and Red Sox do, and eventually the current owners — or their heirs — are going to be selling. People thought the Cubs would bring a billion bucks in a heartbeat, and while they’re still pretty valuable, the billion is not happening. It’s very likely that the insane appreciation franchises have seen over the past 10-15 years is over.

Yes, someone will probably always be around to buy a baseball team, but if they do, it will be at a nice discount and with greatly diminished expectations that they themselves might flip the asset one day. That will cause year-to-year cashflow to assume a much greater importance, which will in turn create greater pressure to keep salaries low and to market everything that isn’t nailed down. Such a thing is likely to change baseball, in some ways for the worse (i.e. I can see the next CBA negotiation getting really nasty) and in some ways for the better (since winning = attendance, it may encourage owners to take a much greater interest in fielding a winning team).

Comments

Goes to show you what time, solid research and a sharp mind can do. Good work!

I don’t think franchise values will tank 75% and I’m certainly not pollyanna-ish in assuming that things won’t fall in price, as he seems to suggest.

I view franchises much like other real estate and coming from a household where my father spent his entire career in commercial real estate, I have come to appreciate the patience in which real estate investors operate. If they think the value of an asset will appreciate, they will buy when it’s low and simply wait it out. MLB, the NFL, etc. are pretty darn exclusive clubs (think beachfront properties). If one of the super-rich has enough of an ego, patience and access to cash (not necessarily credit; could be fellow investors) to acquire a franchise, I think they will still line up to join the club, especially at depressed prices.

Though it’s in Ethan’s block quote, I take responsibility for that line (he gave me some editing rights). He had originally said “that is all gone like a Ted Williams line drive.” Didn’t work for me as much because I don’t immediately think of line drives as resulting in home runs.

On the other hand, we really need to wait to see if revenues fall, and how much. Over the last decade, baseball greatly reduced the % of revenue going to players, so they have a nice cushion to weather the storm. Even if revenue drops 10% this year, it’s still an attractive business.

Agreed, Michael: But let’s not read too much into Ethan’s 75% figure. Having known him and his rhetoric for, damn, pushing 20 years, I think it’s quite safe to say that he meant it as some harmless hyperbole in service as a point rather than a scienfific prediction.

The larger point—that there are strong factors in play working to push down franchise values—is, I think, a good one and remains so even if the depreciation is relatively minor. After all, we’ve seen nothing but hyper-appreciation before now. The Dallas Cowboys sold for $150M in 1989. they’re supposedly worth more than a billion now, and have structured their organization and finances based, in large part, on that huge appreciation. Even if they’re worth more than 25% of a billion—say, they’re worth $700 million—that’s a big deal.

Nice. good stuff and interesting perspective. true pro sports valuations are always going to be difficult because of the uniqueness of the property. commercial real estate is fairly simple in comparison. pro sports teams have a fixed and very limited supply (i think Jason’s beach front property analogy is pretty apt) that rarely, if ever, can be ‘over built’ either through rapid expansion or decline in interest. demand is also extremely inelastic (that might not be the right term, sticky maybe?) but the idea that consumers who fails to support a bad product acquires a social stigma (BANDWAGON!) is pretty unique in the business world. look at the knicks – they have produced a consistently awful product over the last decade or so through woefully inept management, but how much of that translated into lost franchise value? if the quality of a car or food product declined like that you’d quickly find that company’s manufacturer is much bigger trouble.

it will be interesting to see what happens to franchise values over the next several years and beyond. if there is indeed a bubble, and i can definitely see there being one, and then if and how the bubble pops, should be real interesting.

also enjoyed the ‘apotheosis of DCF’. i dont think DCF is going away for good anytime soon but we should hopefully see it wielded as a financial tool a little more carefully in the future (though i also get the feeling this kind of stuff happens after EVERY crash. people have short memories when theyre making big bucks).

I love Ethan’s insights into this, really great work. I do think it is wrong, however to assume that Cuban would have taken a huge bath if he had been allowed to buy the Cubs (allowed? When did we abandon free-market enterprise?)

Mark Cuban is a very savvy, insightful business man and unlike much of professional baseball owners he is a media guy, not a real estate or finance guy. (one except to that is Werner the Sox, owner, and I think that is instructive here). Craig, both you and Ethan are likely correct to assume that Cuban would have over-payed for the franchise and been hard hit by the devaluing that would have occurred.

However, this is the Cubs, not San Diego or Oakland. They should be on par with the Red Sox and the Yankees in terms of their ability to print their own ad-sales dollars. They play in one of the largest markets, a market big enough to support two teams, and they are the more popular team in that market most of the time. They also have a strong team in place and could conceivably win the division, League Championship and the Series (Bartman, goats and choking aside)

It makes sense to believe that winning (especially winning the Series) would mean more financially to Chicago that almost any other franchise. Not only in the money coming from playoff related revenues, but in increased ad-sales, merchandising and ticket pre-sales. I think Cuban would have been very active in trying to create an atmosphere similar to the one in the Boston front-office were winning financially and one the field are given equal importance. In such a scenario, short term value may have decreased as a result of market forces, but long term he could have been transforming the Cubs into an international brand on par with the Yankees and Red Sox and therefore securing their value as much as possible.

I’d love to hear further thoughts on this. Think this is one of the more fascinating issues in baseball business.

I accept that the 75% figure was likely hyperbole, but there are still some flaws in the analysis. For starters, MLB is such an exclusive club and franchises are such an illiquid asset that you can not simply make broad comparisons to markets such as real estate.

More specifically:

1) Stadiums are not just vehicles for related development projects. In fact, it seems as if most stadiums do not enjoy this feature. Rather, they are a source of increased revenue either subsidized in large part by tax payer dollars of favorable financing. Hicks may be an exception, I can’t really think of another team that uses its Stadium as a catalyst for further development. Furthermore, unless such an owner does have a need for cash, as Moores did, I’d imagine that most smart owners would simply regroup and postpone development until the market was more favorable (or in the case of well financed owners, perhaps buy real-estate at depressed values).
2) Are municipal give-aways really going away? If so, why did Miami just approve one for the Marlins? Besides, how many teams without a government subsidized stadium remain?
3) Again, DirectTV just re-upped with the NFL to the tune if $1bn per year, while the MLB Network has enjoyed considerable success. Advertising may retrench a bit in this economy, but ad-men will always pay for primary properties, of which sports remain.

The remaining points all seem to come to the conclusion that the economy is in for a long-term retrenchment. Well, that’s fine, and judging by how the media has covered the downturn, I can understand why someone would have that viewpoint. Of course, such a scenario would be outside the norms. In fact, many economists are now predicting that the recession could come to an end by 2009.

I am sorry, but the doomsday scenario that you articulate has very little basis in fact or precedent. It sounds nice, but doesn’t hold much weight. As Jason from IIATMS originally opined, the egos of a few have a much greater bearing on such a select group than do macro economic principles.

It worth emphasizing what Jason said about the patience of investors. For the most part, owners will not sell their franchises now because they don’t need to. And for the most part, thanks to revenue sharing and the Yankees, even small market teams will remain profitable with a 10% revenue decline.

For example, the A’s expect a 10% drop in attendance which would mean about 200,000 fans, or about $8M revenue to the team (remember, the A’s have a bad stadium deal, in addition to a bad stadium). If they appear to be on their way to the playoffs, they stand pat, since Round 1 in the playoffs will yield on the order of $3M to $5M. If they aren’t on the playoff trajectory mid-July, goodbye Matt Holiday, saving $4M.

The impact of the recession might reduce their profit, but with a move or two the reductions can be mitigated, if not eliminated.

The teams at greater risk are probably teams like Detroit, in hard-hit areas, carrying large payrolls, comprised of some hard-to-move contracts, like Dontrelle Willis.

Creative DCF (discounted cash flow) financing – is no more. From 2004 – 2007 we have seen the apotheosis of DCF – projecting ad infinitum, without risk, the present value of future cashflow to justify the most outlandish purchases at the most inflated prices

I went back to school at McCombs to finish my finance degree in January of 2006, finished in 2007. I basically created my own specialization track that I call “Economics of Finance”, so my last semester I had to take the version of the final F course (a catch-all to tie everything together) which put me with people from all over the department. I was simultaneously in “Corporate Valuation”, so I was hit with DCF like an automatic cannon for weeks. We’ll just say I was unimpressed with the majority of my classmates’ critical thinking abilities when the topic came up (and it did so so repeatedly that any time valuation was broached, heads would swivel my way), so I’d like to engage Ethan for a second on this.

I can’t tell if you’re bringing DCF up here in the context of noting abuses of it, or what. “Without risk” projection? What are the projections? On the one hand, I would constantly have to argue for much more drastic regressions driving down more quickly than others would initially use, but on the other I don’t see a more objective commonly used valuation model than DCF. A properly and honestly calculated DCF should quickly regress growth projections to GDP growth. Are you talking about projections that stay above that level for an extended period of time, or is the problem with projecting GDP-level growth and valuing based on the annuity?

While franchise values may fall, I can’t see how it will have anything to do with a lack of government givewaways. Most sports teams have already gotten their pot of gold from the government and wouldn’t be due for another for decades, long enough from now for the cycle to begin again. In baseball, only 2 teams are still looking for new stadium financing – Oakland and Tampa Bay. Other sports are in a fairly similar situation.

I really don’t see the value of sports franchises falling significantly – certainly nowhere near 75%. What I do see is that those values will stop rising, and the effects of that may be equivalent to the effect of falling values elsewhere.